What is 401(k)

A 401(k) is retirement savings and investing plan that employers offer. A 401(k) plan gives employees a tax break on money they contribute. Contributions are automatically withdrawn from employee paychecks and invested in funds of the employee’s choosing (from a list of available offerings). 401(k)s have an annual contribution limit of $20,500 in 2022 ($27,000 for those age 50 or older) and $22,500 in 2023.

How do you get

You get a 401(k) from your employer. Unfortunately, not all employers offer access to a 401(k) plan.

Advantages

Many employers offer to match a portion of what you save. The 401(k) perk that gets all the headlines is the employer match. If you work somewhere that offers to toss extra money into your account based on how much you contribute — for example, a dollar-for-dollar or 50-cents-on-the-dollar match up to, say, 6% of your contribution amount — stop reading now and fill out the sign-up paperwork. If you do nothing else, at least contribute enough to your account to nab that free money.

Pretax contributions make saving a little less painful. Contributions to a traditional 401(k) plan are taken out of your paycheck before the IRS takes its cut, which supersizes each dollar you save. Let’s say Uncle Sam normally takes 20 cents of every dollar you earn to cover taxes. Saving $800 a month outside of a 401(k) requires earning $1,000 a month — $800 plus $200 to cover the IRS’ cut.

Contributions can significantly lower your income taxes. Besides the boost to your savings power, pretax contributions to a traditional 401(k) have another nice side effect: They lower your total taxable income for the year. For example, let’s say you make $65,000 a year and put $19,500 into your 401(k). Instead of paying income taxes on the entire $65,000 you earned, you’ll only owe $45,500 of your salary. In other words, saving for the future lets you shield $19,500 from taxation.

Investments in the account grow unimpeded by Uncle Sam ... Once the money is in your 401(k), the force field that protects it from taxation remains in place. This is true for both traditional and Roth 401(k)s. As long as the money remains in the account, you pay no taxes on any investment growth. Not on interest. Not on dividends. Not on any investment gains.